Markets don't seem to be too worried about the dysfunction going on in Washington

At this stage of the bull market, investors are contending with
more than a few enigmas: Do valuations even matter? Will interest
rates ever rise? And how do you explain the divergence between
U.S. political dysfunction and the unnatural calm in financial
markets?

That last one has become particularly troubling. Most volatility
measures are near all-time lows while Washington appears in
complete disarray. Nonetheless, investors are likely to continue
to look past political dysfunction, at least as long as financial
conditions remain this easy.

Since then, U.S. economic policy uncertainty has only risen.
Although the index has been higher during the past three months,
overall policy uncertainty is significantly above where it was
pre-election. And yet theVIX
Index, a common measure of equity market volatility, is at
half of its November peak (see the chart below) and bond market
volatility is about a third lower. As surreal as this seems, it
is not inconsistent with history.

VIX Volatility Index

History lessons

In the past, policy uncertainty has been more likely to
coincide with a significant spike in volatility when monetary
and financial conditions were tightening. This was the case in
the summer of 1998, during the emerging markets crisis. While
the federal funds target rate was stable, credit markets had
been tightening financial conditions since the beginning of
that year.

Another example of this dynamic occurred two years later during
the disputed 2000 U.S. election. In the fall of that year, U.S.
policy uncertainty spiked along with the VIX Index, which
nearly doubled from the summer lows. Not only was the U.S.
faced with an unprecedented hung election, but the Federal
Reserve (Fed) had been tightening in the 18 months leading up
to the election. At the same time, credit spreads were up over
200 basis points (in other words two percentage points) even
before the election.

Today we have the opposite set of conditions. Yes, policy
uncertainty has increased and the Fed has been raising rates,
but broader financial conditions are easier than they were at
the beginning of the year:High yield
spreads are tighter, the U.S. dollar is down and the stock
market is having a stellar year. As a result, composite
indicators of financial stress, such as the Bank of America
Merrill Lynch Global Financial Stress Indicator, suggest less
stress than in January.

What could change this happy state of affairs? A few
possibilities. One is that policy uncertainty morphs into
systematic stress—i.e. failure to raise the debt ceiling later
this year. A more likely catalyst would simply involve tighter
financial conditions, potentially a result of the simultaneous
withdrawal of monetary accommodation by the Fed and the
European Central Bank (ECB).

But as long as money remains relatively cheap and plentiful,
investors are likely to stay unperturbed by political paralysis
and dysfunction. When that starts to change, political
uncertainty may suddenly morph back from farce into tragedy.